Home loan and insurance schemes encourage development in climate-risk places, and we are all paying the price

Last year was the costliest year yet for weather-related disasters in the United States, with more than 20 extreme weather events causing losses of more than $1 billion each. Two long-term trends are driving this price up: extreme weather events are becoming more intense, and the United States continues to build more and more expensive homes in risky locations. In 2018, 42% of the US population lived in coastal counties (areas particularly vulnerable to coastal storms and sea level rise), even though these counties represent only 10% of the country’s land area. This begs the question: Why do people build and buy homes in places at predictable and persistent risk of climate-related disasters?

One of the reasons for our seemingly irrational drive to invest in high-risk homes is that the financial costs of extreme weather events are spread across multiple players. No person, company or public agency bears the full cost of damage. Individuals’ out-of-pocket costs for their housing and transportation choices do not fully reflect the environmental damage they cause or the risks they incur. Complex and opaque ways of allocating financial risk reduce the incentive for any party to change its behavior.

The financial costs of disasters are spread among many people, businesses, government agencies and taxpayers

In 2017, Hurricane Harvey hit the Gulf Coast, flooding over 300,000 homes. Having your home destroyed in a hurricane obviously inflicts substantial financial loss on homeowners, not to mention physical danger and emotional distress. But the financial damage extends far beyond individual owners in ways that aren’t always easy to observe.

A breakdown of home buying costs gives us a first look at the distribution of risk. Let’s take a hypothetical example: suppose that in 2015 a home buyer bought a house in Galveston, Texas, overlooking the Gulf of Mexico. That year, a typical house in Galveston cost around $250,000. Most home buyers in the United States do not buy homes with cash; they typically pay 10-15% of the purchase price up front and borrow the rest from a bank or other mortgage lender. So when Harvey hit in 2017 and flooded his home, our hypothetical buyer had likely accumulated about $45,000 in home equity (Figure 1), with over $200,000 left to pay on the mortgage, backed by a gravely damaged and devalued.

Figure 1: New owners have relatively low net worth

Purchase Price (2015) $250,000
Deposit 15%
Total Home Equity (2017) $45,137
Outstanding Mortgage Balance (2017) $204,863

Source: ACS Median Home Value.

Note: Assumes an interest rate of 4.0% on a fully amortized 30-year fixed rate mortgage, based on Freddie Mac’s Prime Mortgage Rate Survey.

Does this mean that the bank that issued the mortgage will have to absorb $200,000 in losses? Not necessarily. Leaving insurance aside for now (which we’ll get to later), it’s likely that the bank won’t be the ultimate loser in this scenario, as shown in Figure 2.

About two-thirds of US mortgages are not retained on the balance sheets by the original lender. Instead, mortgages are sold to intermediaries, who bundle them with other loans and sell the income stream to investors – a process called “securitisation”. The two main intermediaries, Fannie Mae and Freddie Mac, are Government Sponsored Enterprises (GSEs) – quasi-public enterprises that were originally licensed by the federal government. Under normal housing market conditions, Fannie and Freddie insure investors against the risk of borrower default. Since the Great Recession, Fannie and Freddie have been under federal trusteeship, meaning they pay a portion of their profits to the US Treasury Department and are subject to oversight by Congress and the Federal Housing Finance Agency.

The result of this convoluted arrangement is that the federal government is ultimately responsible for approximately $6.9 trillion in outstanding mortgage debt, including many properties in high climate risk locations. Fannie and Freddie require homeowners in designated flood-prone areas to carry flood insurance, but the agencies do not consider localized climate risk when securitizing loans.

Property insurance programs distort incentives to reduce risk

Private and public insurance programs also play a role in encouraging risky development. Mortgage lenders require home buyers to carry home insurance to protect the lender in case something happens to the property. However, the extent to which private insurance companies reimburse homeowners after weather-related disasters varies widely. Although most policies cover wind damage (such as trees falling through the roof), they generally don’t protect against flood damage, often the most expensive damage caused by hurricanes.

The federal government has become the primary flood insurer, through the National Flood Insurance Program (NFIP). However, the researchers pointed to numerous issues with the NFIP, including the accuracy and timeliness of its maps, an issue that the Federal Emergency Management Agency (FEMA) is trying to correct. For example, only about 20% of New York properties that were flooded during Hurricane Sandy in 2012 had flood insurance, as the storm surge extended far beyond areas identified as at high risk. Many homeowners who purchase NFIP policies pay premiums well below the actuarially fair level, which subsidizes homeowners who live in high-risk locations while leaving the NFIP financially unstable.

Pricing climate risk in mortgages would discourage development in risky locations, but could hurt low-income homeowners

There are several ways our housing finance system could discourage development in climate-risk locations. At one extreme, Fannie Mae and Freddie Mac could refuse to securitize mortgages on properties in high-risk locations. Most banks would then be unwilling to offer mortgages in these areas, which would discourage buyers from moving there unless they were prepared to pay everything in cash and bear most of the risk. . A less drastic option would be for Fannie and Freddie to continue to securitize loans, but build the location-specific risks of weather events into the cost of mortgages through higher interest rates or lower loan-to-value ratios. Given that Fannie and Freddie are still under conservatorship, it’s likely that any change in their approach to climate risk would require congressional authorization, which is by no means an easy political lift.

Equity considerations introduce another layer of complication into the decisions of policy makers. Not all homes in risky locations are beachfront vacation homes owned by wealthy households. In many parts of the country, low-income people live where land and housing are relatively cheap, which often means high-risk places. Black and Latino or Hispanic households make up a disproportionate share of long-term homeowners in many high-risk neighborhoods. More accurate pricing of climate risk in mortgages and insurance would drive down property values ​​in these neighborhoods, exacerbating racial wealth gaps.

Of course, homes are only part of the built environment. Transport, water and other infrastructure systems are also increasingly vulnerable to climate risks. Investments in more resilient infrastructure, such as water-permeable roads and distributed rain gardens, can better respond to these risks. Increasing public and private investment in these types of improvements holds great promise in the years to come.

Until now, national climate policy debates have failed to address the complex ways in which housing finance and property insurance encourage development in the wrong places. Reforming these systems to discourage risky behavior while alleviating equity concerns is key to reducing the economic and human costs of climate change.

About Gene Schafer

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